Why Asset Managers Shouldn’t Ignore the SEC’s PIMCO Probe

The US Securities and Exchange Commission’s (SEC) Wells notice to PIMCO over valuations points to market-wide problems with fixed-income valuations, according to Morningstar’s top specialist.

The Newport Beach-based bond house revealed Monday that SEC staff intend to recommend action against the firm for allegedly inflating mortgage bond values in its Total Return Active ETF.

“The broader fixed-income pricing issues at hand are neither unique to PIMCO nor intrinsic to ETFs.” —Michael Herbst, MorningstarWhatever the investigation reveals about PIMCO, Morningstar’s head of fixed-income manager research has argued that it shows the potential consequences of market illiquidity, manager leverage, and standard bond trading practices.

“Without more information, we can’t speculate whether PIMCO acted appropriately or inappropriately,” wrote Michael Herbst in an analysis published Thursday. “But we do know that the broader fixed-income pricing issues at hand are neither unique to PIMCO nor intrinsic to ETFs.”

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The daily value of an ETF like Total Return Active—a tracker to PIMCO’s flagship fund—partly depends on assets vastly less liquid than their vehicle, Herbst pointed out.

When PIMCO’s traders bought the small batches of mortgage-backed securities they’re under scrutiny for, the price may have reflected the awkward lot size and seller’s circumstances as much as the underlying value of the assets. Repacked by PIMCO (or any other large bond manager or asset owner) and free of external pressure to sell, Herbst noted that the same securities would be worth more.

Finding those opportunities is part of what makes a great fixed-income manager. But in his view, it also makes for hazy valuations and compliance vulnerabilities.

“It’s very plausible that an asset management firm with any bargaining power (and PIMCO by reputation is a fierce negotiator) could offer to take odd lots of less liquid nonagency mortgage-backed securities off a dealer’s hands for a discounted price, or that a dealer looking to get those securities off its books or curry favor with PIMCO could make those securities available to the firm at a discount,” Herbst wrote.

Whether those factors were or weren’t at play in the Total Return ETF transactions has not yet been revealed. Either way, he argued, trading and pricing in the fixed-income market are such that they certainly could have been.

And while the SEC has (for now) singled out PIMCO for scrutiny, its competitors have faced the same confluence of illiquidity and lot-dependent pricing that invites flexible valuations into a rigidly regulated sector.

Herbst and his colleagues haven’t changed their view on PIMCO, which Morningstar last rated neutral overall, with a C for stewardship.

“There is nothing definitive about a Wells notice,” he concluded. But for managers playing in the same market, there is definitive reason to watch how the SEC views their behavior.

Read Michael Herbst’s entire post: “PIMCO Put on Notice.”

Distressed private equity fund managers are most likely to consistently deliver strong performance in multiple funds, compared to other managers in the asset class, according to Preqin.

The data firm found managers of distressed debt, special situation strategies, and turnaround strategies that performed in the top quartile in the past went on to raise another successful fund.

Nearly three-quarters of distressed private equity funds that performed above the median raised another successful fund in the future.

Specifically, some 46% of distressed funds scoring in the top quartile in performance went on to have successor funds also ranking in the top quartile.

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On the other hand, only 61% of overall private equity funds in the top half of performance were able to continue their success, the report said.

“For distressed private equity funds in particular, the performance of the predecessor vehicle is greatly indicative of the performance of the successor fund in terms of quartile ranking,” Preqin said.

However, distressed strategies that ranked in the lower quartiles were less likely to raise successor funds in the top quartile than all other private equity funds, the report said.

According to Preqin’s data, just 15% of distressed strategy managers in the third-quartile and 6% in the bottom-quartile were likely to raise top-performing funds going forward.

Other private equity strategies ranked in the bottom half in performance did a little better, with 33% moving on to raise a top-quartile successor fund.

Though investors shouldn’t rely completely on track records as a guarantee of future returns, Preqin noted it is important to take into the relationship between predecessor and successor funds in performance.

“Assessing how well a fund will perform is a continuing challenge for institutional investors and a strong track record is one of the most important factors that investors take into account when considering making new commitment to the private equity asset class,” the report said.

Preqin Distressed PE